Chapter 6: Reinsurance products - types

Question 1

Quota share

Answer 1

A form of proportional treaty reinsurance whereby the premiums and claims for all risks covered by the treaty are split in a fixed proportion between the insurer and reinsurer

Question 2

Commissions payable under a quota share agreement

Answer 2

• return commission
• override commission
• profit commission

Question 3

Return commission

Answer 3

The reinsurer will reimbirse the direct writer with some percentage of the premium to help cover the aquisition expenses.

Question 4

Override commission

Answer 4

Commission over and above the return commission, compensating the direct writer for attracting and administering the business (extra work).

Question 5

Ceding commission

Answer 5

The sum of the return and the override commission

Question 6

Profit commission

Answer 6

Commission the reinsurer pays the direct writer as a reward for passing on good business.

Question 7

Advantages of quota share

Answer 7

• it spreads risk, enabling insurers to write larger portfolios of risk and encourage reciprocal business
• directly improves the solvency ratio and helps the insurer to satisfy the statutory solvency requirement
• it is administratively simple
• the commission may help with cashflow

Question 8

Solvency ratio

Answer 8

Free reserves divided by net (of reinsurance) written premiums

Question 9

Disadvantages of quota share

Answer 9

• cedes the same proportion of low-variance and high-variance risks
• it cedes the same proportion of each risk irrespective of size
• passes a share of any profit to the reinsurer
• it is unsuitable for unlimited covers

Question 10

Surplus reinsurance

Answer 10

A form of proportional reinsurance where the proportions are determined by the cedant for each individual risk covered by the treaty, subject to restrictions defined in the treaty

Question 11

Estimated/expected maximum loss (EML)

Answer 11

The “estimated maximum loss” is the largest loss that is reasonably expected to arise from a single risk

Question 12

What limits can the reinsurance treaty soecify?

Answer 12

• insurer’s minimum retention
• insurer’s maximum returntion
• reinsurer’s maximum level of cover

Question 13

Minimum retention level

Answer 13

This is the minimum level of retention the reinsurer requires to prevent the insurer from having too little interest in the risk. This requires the insurer to retain all risks that fall below the minimum retention

Question 14

Maximum retention (R)

Answer 14

This is the maximum level of retention for any risk to be included in the treaty and will be specified in the treaty.

Question 15

Number of lines of cover (L)

Answer 15

This is specified in the contract and is used to calculate the maximum cover available from the reinsurer. The maximum cover available from the reinsurer is calculated as L times R

Question 16

EML formula

Answer 16

EML = r x (L+1)

Question 17

What is the main difference between quota share and surplus treaty?

Answer 17

Quota share has the same proportion of every risk ceded to the reinsurer whereas the proportion ceded in surplus reinsurance varies from risk to risk

Question 18

Advantages of surplus reinsurance

Answer 18

• it enables the insurer to write larger risks, which might otherwise be beyond its writing capacity
• it enables the insurer to choose, within limits, the size of the risk it will retain
• it’s useful for classes where a wide variation can occur in the size of the risk
• it helps spread risks
• the commission may help with cashflow

Question 19

Disadvantages of surplus reinsurance

Answer 19

• the admin is more complicated than for quota share, owing to the need to assess and record seperately for each risk the amount to be ceded
• it is unsuitable for unlimited covers and personal lines cover where potential losses are small compared to the insurer’s resources
• the treaty terms may not be flexible enough, so that it may not cover the largest risks without the need for extra negotiation

Question 20

Working layer

Excess of loss reinsurance

Answer 20

The first layer above the cedant’s excess point (retention) where moderate to heavy loss activity is expected by the cedant and reinsurer

Question 21

Indexed limits

Excess of loss reinsurance

Answer 21

Where inflation has significant effect on the cost of claims, a stability clause may be applied to the excess point. This is so that the reinsurer doesn’t receive a higher proportion of risks purely because of inflation

Question 22

Commission in excess of loss reinsurance

Answer 22

Return commission and override commission are not normally relevant to excess of loss reinsurance. They may as well just charge a lower premium (there is a single premium for XL reinsurance)

Profit commission is possible. It is inappropriate for very high layers of XL treaties, where the reinsurer only expects to pay out in exceptional circumstances

Brokerage commission is very likely paid

Question 23

Reinstatements

Excess of loss reinsurance

Answer 23

After a number of seperate events have collectively drained the available cover on the XL arrangement, the reinsurer will allow one or more reinstatements of the cover.

Reinstatement premiums (more or less than original premium scaled down for unexpired risk term) are payable.

Question 24

Pro rata as to amount reinstatement premium

Excess of loss reinsurance

Answer 24

A proportionate premium according to the layer that’s been burnt through is charged.

Question 25

Pro rata as to time reinstatement premium | Excess od loss reinsurance

Answer 25

Where the period of cover remaining also affects the reinstatement premium

Question 26

Deductibles | Excess of loss reinsurance

Answer 26

For all forms of excess of loss, it is possible that the reinsurer will cover only a proportion of the claims within the layer, by applying a deductible. Gives direct writer more incentive to keep the claim settlements low - lowers reinsurer's exposure to moral hazard of sloppy settlement procedures for large claims

Question 27

Main types of excess of loss reinsurance

Answer 27

- risk XL - aggregate XL - catastrophe XL

Question 28

Risk XL

Answer 28

A type of XL reinsurance that protects against large individual losses Reinsurer indemnifies an insurer for the amount of an individual loss in excess of the excess point - in return for a premium from the direct writer Can be written facultatively or by treaty

Question 29

Aggregate XL

Answer 29

Reinsurer indemnifies the insurer for a cumulative, aggregate amount of losses in excess of a specified aggregate amount. Losses can be aggregated by: - event - peril or cause - class

Question 30

Catastrophe XL

Answer 30

A form of excess of loss reinsurance which, subject to a specified limit, indemnifies the ceding company against the accumulated loss. This is in excess of a specified excess point (retention), resulting from a catastrophic event or series of catastrophic events.

Question 31

Hours clause

Answer 31

A clause within a catastrophe reinsurance treaty that specifies the limited period during which claims can be aggregated for the purpose of one claim on the reinsurance contract. Common examples are 24 or 72 hours.

Question 32

Advantages of excess of loss reinsurance

Answer 32

- allows insurer to accept risks that could lead to large claims - reduces the risk of insolvency from a large claim, an aggregation of claims or a catastrophe - reduces claim fluctuations and smoothes results - helps make more efficient use of capital by reducing variance of claim payments

Question 33

Disadvantages of excess of loss reinsurance

Answer 33

The insurer pays a premium to the reinsurer that in the long run, if priced accurately, will be greater than the expected recoveries under the treaty. Occasionally, XL premiums may be considerably greater than the pure risk premium for the cover

Question 34

Stop loss

Answer 34

A form of excess of loss reinsurance that indemnifies the ceding company against the amount by which its losses incurred during a specific period (usually 12 months) exceed either: - predetermined monetary amount - percentage of the company's subject premiums (loss ratio) for the specific period. Subject premiums are the premiums for the account that's being insured.

Question 35

Purpose of financial reinsurance

Answer 35

Risk financing rather than traditional risk transfer. Typically a multi-year contract aimed at reducing the cedant's cost of capital by means of earnings smoothing. The contract reduces year-to-year earnings volatility but it provides limited risk transfer over the whole contract period.

Question 36

Features of financial reinsurance

Answer 36

- involves a small element of risk tranfer from cedant to reinsurer - involves investment type risk - multi-year contract term - explicit inclusion of investment income in the contract - sharing of results with the cedant - risk transfer and risk financing are combined

Question 37

Types of (or finite risk) reinsurance

Answer 37

- pre-funded arrangements - post-funded arrangements

Question 38

Pre-funded financial reinsurance arrangements

Answer 38

The insurer pays premiums into a fund held by the reinsurer (which earns interest) and claims are paid from the fund

Question 39

Post-funded financial reinsurance arrangements

Answer 39

The reinsurer pays the losses and the insurer pays back the losses over time.

Question 40

Specific types of financial reinsurance products

Answer 40

- time and distance deals - spread loss covers - financial quota share - industry loss warranties

Question 41

Time and distance deals

Answer 41

The insurer pays the reinsurer a premium and in return, the reinsurer pays an agreed schedule of claim payments. This has the effect of discounting the reserve of the insurer for the time value of money. Improves apparent solvency position if payments can be treated as reinsurance recoveries - can be shown at face value in balance sheet.

Question 42

Spread loss covers

Answer 42

The insurer pays an annual or single premium to the reinsurer for the coverage of specified claims. These accumulate with interest (contractually agreed) in an experience account, the balance of which is settled at the end of the multi-year period. These may be used to provide liquidity and security to the insurer and may be used for catastrophes.

Question 43

Financial quota share

Answer 43

This is quota share purchased to obtain reinsurance commissions for financing assistance. Financing is achieved by overcompensating (paying more than a normal reinsurance commission) in initial period and undercompensating (paying less than normal reinsurance commission) over a period thereafter.

Question 44

Industry loss warranties (ILWs)

Answer 44

These are a type of reinsurance that pays out based on industry losses rather than losses to individual insurers. Basis of cover isn't indemnity. The reinsurer pays out a specified fixed amount to insured if: - there has been an insured loss of a particular type - a second indemnity-based trigger is breached, based on the value of the losses incurred by the insured = insurable interest

Question 45

Run-off reinsurance

Answer 45

It could in practice involve any treatment or rocessing of any closed book of business. The reinsurance of a closed tranche is just one possible run-off solution. Aim is transfer of reserve development risk. Provides cover against the insurer's earnings volatility arising from past activities

Question 46

Circumstances where run-off reinsurance is sought

Answer 46

- corporate restructuring - mergers and aquisitions - closing lines of business - economic changes in the value of the liability - regulatory, accounting or tax changes - legal developments, for example court decisions

Question 47

Main types of run-off reinsurance

Answer 47

- adverse development cover - loss portfolio transfers

Question 48

Adverse development cover

Answer 48

Reinsurer agrees, in return for a premium, to cover the ultimate settled amount of a specified block of business above a certain pre-agreed amount. Protects cedant against significant reserve deterioration on run-off business. Caps the liability and protects balance sheet from any further development on existing losses and from future losses in respect of old business No tranfer of reserves from insurer to reinsurer.

Question 49

Loss portfolio transfers (LPTs)

Answer 49

The liability for a specified book of business is passed in its entirety from one insurer to another. Policyholders are informed of this novation and the deal needs to be approved in court. Original insurer transfers the reserves and remaining exposure to new insurer. There is likely a premium in addition to exisiting reserves. Includes a claims handling service. All adverse claims risk and investment income passed to new insurer.

Question 50

Novation

Answer 50

The transfer of the rights and obligations under a contract from one party to another.

Question 51

Advantages of loss portfolio transfers (LTPs)

Answer 51

- can improve the credit rating of the original insurer - new insurer will gain diversification if not already in this area and achieve a larger client base. - specialist players in the market may be able to run-off such portfolios more profitably than the original insurer

Question 52

Disadvantages of loss portfolio transfers (LPTs)

Answer 52

- assets may need to be realised to pass on the value of the reserves to accepting insurer - important if there's mismatching or if tax losses/gains would be crystalised - if new insurer defaults, this could damage the reputation of the original insurer - the transfer may require the buy-in of reinsurers where there are existing reinsurance agreements on the portfolio - There'll be an associated cost to the original insurer of the risk transfer, which depends on the current risk appetite of the market. This cost is the premium payable plus the lost investment income